Policymakers are obsessed with capital, and it's easy to understand why. It is central to confidence in the banking system. It is quantifiable. It's tangible.
Those are all good things, and everyone agrees a solid banking system is founded on a sound capital base.
But the focus on capital may be creating a false sense of security, and it may be overshadowing other, equally important issues that are central to preventing the next crisis, like how well banks are managed and how well supervisors do their jobs.
"Capital is a component of good risk management. Nobody would disagree with that. But it is only one component, and there is a tendency to latch on to capital because it is measurable," said Eugene A. Ludwig, CEO of Promontory Financial Group and a former comptroller of the currency. Other factors, he said, are "less tangible but every bit as important."
John D. Hawke Jr., another former comptroller who is a partner at Arnold & Porter law firm, agreed.
"Increasing capital is kind of a fool's errand unless you are measuring capital accurately, and the real problem we've had as regulators is we can't get a good handle on the real value of capital," Hawke said.
Today's fixation with capital calls to mind policymakers' reaction to the savings and loan crisis. After hundreds of institutions failed in the late 1980s and early 1990s, Congress mandated something called Prompt Corrective Action. As a bank's capital declined, regulators were supposed to take increasingly aggressive actions including choking off dividend payments and making C-suite changes. When a bank's capital hit 2%, supervisors were to seize it, a move designed to minimize losses to the Deposit Insurance Fund.
That's not how it worked out. Years of record earnings bred complacency; regulators did not act quickly when capital levels fell and even more important, as Hawke pointed out, no one really understood the value of a bank's capital in a crisis. It turns out that while capital is easier to measure than other factors like management talent it is still far from a science. Once a bank is in trouble, it never has as much capital as the regulators had figured.
Even the advent of "risk-based capital," which attempts to adjust capital needs based on the risk posed by various assets, isn't a solution because time and again the risk assigned to a class of assets has been underestimated.
To be sure, Basel III is more sophisticated and will be augmented by tools provided by the Dodd-Frank reform law, including mandated stress-testing.
But it is capital that is getting the bulk of regulators' attention, and ironically the last crisis was not a caused by a shortage of capital but rather by a lack of liquidity.
U.S. regulators are working with counterparts around the world on new standards to ensure a company has the funding it needs when problems arise. But those rules are not done yet and it is still unclear if they will work.
And while regulators are tackling both capital and liquidity under the Basel Committee on Banking Supervision, there is a big gap in how supervisors plan to deal with troubled banks that operate across borders.
How "too big to fail" institutions are resolved is a key issue and one where the U.S. is going it alone with its plan to end bailouts and rely on bridge banks to unwind large, complex banks.
As Karen Shaw Petrou of Federal Financial Analytics put it to me: "The rest of the world is not using the 'shoot 'em but let them die slowly' approach. The rest of world is enshrining 'too big to fail' and making companies and their investors pay for it" through special taxes and bail-in debt.
That's not to say the U.S. approach is wrong. It's just that a coordinated approach now is preferable to the likely outcome — every country for itself when disaster strikes.
Preventing the next disaster is of course the goal and, as Ludwig put it, rather than throwing a "one-size-fits-all blanket, i.e. capital, over the whole system" regulators should be assessing how they failed — and how bank managers and boards of directors failed — to prevent the real estate bubble from blowing up in the economy's face.
There is no doubt the agencies are full of people working long and hard to thwart another disruptive and expensive financial emergency. But shining such a bright spotlight on capital can leave a lot of other issues in the dark.
"It is definitely fair to say there is an overemphasis on capital at the expense of something, and it behooves us to spend some time and attention on what that something is," another former high-ranking federal regulator said. "My concern is we so overreacted that we are cutting off or greatly limiting economic growth or channeling it to nonbank channels where who knows how the risks will sort out."
The more complicated and layered capital rules become, the more expensive it is to be a bank. Some will shrink to meet higher standards, and that will reduce earnings.
If lower returns lead investors to move their money to higher-yielding businesses, then tougher capital requirements will have backfired.
What's more, as the official above noted, going too far on capital could entice money and risk to move outside the banking system. Encouraging the emergence of a new shadow system is hardly in anyone's interest.
So what, beyond capital, should regulators be focused on? Here's a list based on interviews with many former regulators:
• Enforce prudent underwriting standards and ensure banks are run by smart management teams and informed as well as engaged boards.
• Spot the next hot products and services and figure out how to contain the risks posed by that explosive growth. Regulators must find a way to tell bankers no, rather than watching them all run after the same assets.
• Stop trying to fix troubled institutions by letting a bigger company buy them, which too often simply compounds the problem. Force serial acquirers to integrate targets effectively.
• Assess whether the agencies have the people — both in terms of numbers and expertise — to do the enormous job before them.
• Make sure important supervisory reforms get the proper attention rather than take a backseat to all the work necessary to write the rules implementing the Dodd-Frank Act.
It's a tricky line to draw, but policymakers must remember capital is not a cure-all.